This page is a collection of reflections, contemplations, thoughts; about life, about death, about people, about stock markets, about science, about scientists, about economy, about economists, about art, about artists, about books and authors...

Wednesday, July 17, 2013

Aditya Agarwal,
the Country Manager of Morningstar India, has 20 years of experience in the
financial services and investment management industry. He was the promoter of
one of India’s leading fund research companies, ICRA Online, and is highly
regarded as a subject matter expert on mutual funds. In a conversation with
Professor Vikram Kuriyan and Nupur Pavan Bang of the ISB’s Centre for
Investment, Agarwal discussed the reasons for the slow growth of the Indian
mutual funds industry compared to developed markets and explained why investor
education and awareness is required.

India accounts for 18% of the world’s population but only 0.37%
of the global mutual funds industry in terms of assets under management, as per data from the
Investment Company Institute. India has one of the highest savings rates in the
world at about 33% for the year 2012. But this money does not find its way into
the stock markets or mutual funds. Why is this so?

It is true that only a meager fraction of the savings in India
goes into stocks or mutual funds. Indians prefer real assets such as gold and
property to stocks or equity mutual funds. Many risk-averse investors prefer to keep their money safe with bank fixed deposits, and
some even prefer to hold cash.

The primary reason for this is a general lack of awareness among
individual investors about how stock markets work. Thirty years ago, the BSE
(Bombay Stock Exchange) Sensex was at 125, whereas 10 years ago, it was near
4,000 levels. Thus, if you held a portfolio of the top blue-chip stocks similar
to the BSE Sensex and left it untouched, your wealth would have grown 150 times
and 4.5 times in 30 and 10 years respectively, or at a compounded annual growth
rate (CAGR) of about 18% in both cases.

However, in most cases, investors fail to recognise that stocks
and mutual funds are best when held over a longer term, say five years or more, for the volatility to
even out, and instead, trade in stocks for the short term, leading to
disappointing results. Financial literacy needs to improve in the country.
Despite all the efforts from the regulator and various investor education
initiatives run by fund companies, financial planners, and so on, the buy-in
from investors just isn’t there. Funds are still not bought; they have to be sold
to investors.

It is no secret that stocks generally outperform all other asset
classes over the long term – this has been demonstrated and proven in every
market over different time frames; however, a relative lack of understanding of
this among investors, and as a result, their bitter experience with the asset
class, has resulted in Indian savings not being channeled into the asset class
as much as they should be.

Private players entered the mutual fund industry in 1993. The
industry is 20 years old today, but yet it is far from mature. What are the
reasons for this? In terms of accountability, mutual funds have not performed well
or beaten the benchmark consistently.

The entry of private players has definitely raised the standard
and professionalism of the industry, but that is unlikely to have a bearing on
the industry’s growth. The reason for this is that with 75% of the industry’s
assets in debt and liquid funds, it serves institutions well to park their
surplus funds and gain a tax advantage. Until the average retail investor starts to
believe in a big way that wealth can be created from equity investments, we won’t
see the industry maturing in the way it has in developed markets.

On the question of funds not performing well, we often confuse
poor returns stemming from the market’s dismal performance during the past five
years (five years ago, stocks were nearing the end of a multi-year bull run)
with relative underperformance. One cannot expect equity funds to post sterling
returns when the market itself has given zero or negative returns. At the
relative level, we need to do more comprehensive studies to see how many funds are
underperforming relative to their benchmarks before concluding that it is an
alarming picture. It all depends on which way you look at the data.

For example, a recent study pointed out that over the past five
years, over 50% of equity funds underperformed their benchmarks. But the study looked
at the absolute number of funds, and not at the funds in light of their assets
under management (AUM). Consider, for instance, a hypothetical category
comprising two funds managing INR one billion (100 crores) and INR nine billion
(900 crores) respectively. If one of them underperforms, it means that 50% of
the funds underperformed. However, if the bigger fund outperforms the
benchmark, then we can say that 90% of the AUM outperformed. At the asset
level, a preliminary analysis we did over the same time period showed that
about 80% of funds (assets) outperformed their benchmarks because the more successful
funds tend to manage larger assets.

It is the perception of investors that mutual funds do not give
returns. Year on year, mutual funds may perform well, but investors are actually losing money. The
number of investors who lose money is greater than the number of investors who
make money.

Over the long term, equity mutual funds have shown robust
performance, but in the short term, stocks and stock funds can post
disappointing results. It’s the nature of the beast. Investors often tend to
have a herd mentality and flock to asset classes after they have seen years of
outperformance and the markets are at near peaks. The recent mania for gold and
for stocks towards the end of 1999 and 2007 are a case in point here; investors
entered the markets at precisely the wrong time and burnt their fingers badly.

Then there is also the problem of capital-weighted return.
Suppose a fund with INR one billion (100 crores) in assets gains 100% in one
year. By the end of year one, due to the fund’s stupendous performance and investors
chasing it and putting money in it, the asset size swells to, say, INR 10
billion (1,000 crores). Then the next year, the fund returns a negative 50%. In
such a scenario, the net return at the fund level would be the same, but far
more investor money would have been lost as the fund had fewer assets when it
gained and more when it lost. At Morningstar, we call the concept “investor
return,” and in countries where flows data is available, we often see a
considerable difference between a fund’s total return and investor return (or
the internal rate or return investors got, capital-weighted) over any time
frame.

In markets such as the United States (US), the gap between a
fund’s investor return and total return is often glaring and remains wide for
some volatile categories of asset classes. We would love to see the difference
between the two for Indian funds, but we do not have enough disclosure data to
calculate it. However, considering that Indian markets are more volatile than
many other markets and because, as we mentioned earlier, investors tend to pour
in capital more often than not at the wrong time or near market peaks, we think
the gap would be significantly large.

Until we have sufficient investor awareness and disciplined,
buy-and-hold investing becomes more widespread, we will see the problem of
investor disappointment manifest itself even if overall fund performance is
good.

People in India view insurance only as a means of tax saving.
Are mutual funds going the same way? If so, what can be done to prevent such a
mindset?

Mutual funds will remain a push product as long as investors
feel more comfortable with the 9% stable return that fixed-income instruments
such as fixed deposits (FDs) provide. They tend to forget that this 9% return
is often entirely eaten into by inflation and ignore the higher 20-21% return
that the average mutual fund has logged over the past 10 years, albeit with
greater volatility.

A big driver of this growth could be the introduction of
mandatory savings into equity products by the government, something similar to the
401k in the US (a kind of defined contribution plan to save for retirement).
The (National Pension System) NPS is a start, but if we revamped something like
the Employees’ Provident Fund (EPF) and partly linked its returns to the
market, 10 or 20 years down the line, investors would have, out of force,
learned the magic of disciplined investing in stocks.

Over the course of time, as investors develop greater comfort
with equities, we will see more investors come out and buy equity mutual funds.

Exchange-traded funds (ETFs) have not done well in India,
whereas they are popular across the world. ETFs have only about 2% of the
market share in spite of their many benefits. Is this due to weak distribution networks
and low sales commissions for agents?

ETF is a wonderful product as seen by its popularity in the
West, offering passive, often niche strategies for investors who focus on asset
allocation. But ETFs are far ahead of their time in India. Active management is
preferred here, and we do see large outperformances by managers compared to the
West, where beating the market is becoming exceedingly difficult. Further, investing
in ETFs in India also has its set of operational issues. One of the challenges
for small investors who do not invest in stocks is the lack of a demat account.
To buy an ETF, one needs to open a demat account, and not everyone wants to do
that. The point about low commissions is also one of the key reasons why they
are not sold as widely in India.

One argument put forward by some commentators is that if Indians
prefer to invest in gold and real estate, why not give them funds that invest
in gold and real estate?

We do have gold funds and ETFs that offer an excellent way to
invest in the yellow metal. Real estate mutual funds are a different equation,
however. Asset management companies say they face practical difficulties with
respect to regulations, valuations, and so on.

Who is accountable for the performance of the funds? Do fund
managers in India have the necessary qualifications to manage thousands of
crores of someone else’s money? A person without a background in finance may not be the
right candidate to manage funds. What is your view?

As a whole, we believe that the industry’s assets are in good
hands with adequately qualified people to manage the money. Of course, there
will always be times when some managers are outperforming while others aren’t,
but that is the nature of the market. If some are underperforming for a long
time, you will see investors leaving the fund and assets drying up and going to
better performing managers and funds. It is a self-correcting mechanism.

At the ecosystem level, we believe the regulator has drawn up
enough regulations and put in place processes that safeguard investor interest.

What are some of the things that the Securities and Exchange
Board of India (SEBI) can do to better support the industry? What are the
regulatory bottlenecks that keep the industry from growing?

We believe SEBI has done a brilliant job of regulating the
industry, especially after the 2004-2007 boom and subsequent crash when some of
the practices were less than ideal. The abolition of entry load and the introduction
of direct plans are good moves to help the investor save on expenses and make
the product more attractive. The regulator has set the ground for the industry
to grow in a sustainable manner. Now, it is left to market performance to pick
up and start drawing in more investors, and for investor awareness to increase,
all of which will launch the industry into its next growth orbit. That said, we
would like to see a greater focus on independent research and higher levels of
transparency and disclosure in the industry.

You spoke about research. What research topics in this industry
would you advise budding researchers in India to pursue?

If the question pertains to fund research, I would like to point
out the acute lack of awareness that exists in India on this subject. For many
distributors, recommending funds means picking the recent top performers. At
Morningstar, our unique approach, developed through decades of expertise in the
field, is to offer investors not just unbiased and independent but also
cutting-edge research that helps investors take informed decisions. I would
urge budding researchers to try and stay up to date with the best global fund
research practices, qualitative and quantitative, followed by our firm and also
our peers. Knowledge, information and widening your perspective will give you
an edge over others.

The
globalisation of the Indian stock market is reflected in India’s sophisticated
institutional capacity, facilities and international practices, which have
increased capital availability and market liquidity in India by attracting
FIIs.

Unimpeded
financial markets allowed Indian companies to cross-list in international
exchanges and raise capital by issuing depository receipts and convertible
bonds.

Issued by US
banks (acting as custodian), ADRs are negotiable certificates that represent
the ownership of shares in non-US companies. They enable US investors to invest
in foreign securities and non-US investors to invest in US markets.

These
instruments provide a unique opportunity to investigate interaction channels
between the US and other equity markets, both in synchronous (eg. US and
Canada) and non-synchronous (eg. US and India) time settings.

Information
transmission

In
synchronous settings, ideally speaking, in the absence of any frictions like
capital control or illiquidity or differential tax structure, information
should flow into both the markets at the same time instance.

However, in
non-synchronous settings like NYSE/Nasdaq in the US and NSE/BSE in India,
various issues of market efficiency such as price transmission and price
discovery beckon investigation.

On any
calendar day, the Indian market opens first and the US market is the last to
close. Therefore, if markets are efficient, the ADRs should react to new
market-wide information in India when US markets are closed and vice-versa.

If the
exchange rate remains approximately constant over time, an upward (a downward)
movement of the underlying assets will move up (down) the corresponding ADR’s
price.

On a given
calendar day, Indian markets close first. Therefore, if the two markets are
fully efficient and the prices of underlying shares truly affect the prices of
ADRs, then we expect that a shock from the underlying shares would be reflected
in ADR prices (as well as price changes) in the same calendar day. However, a
shock in the previous trading day should not affect the ADR.

Exchange rate
impact

ADR prices
get indirectly influenced by the INR/USD rate. For foreign portfolio investors,
directly holding INR denominated shares, profits from investments in Indian
markets are subject to exchange rate risk.

An upward (a
downward) movement of the underlying stock coupled with an appreciation (a
depreciation) in INR/USD rates will exert greater pressure on that particular
Indian ADR to move up (down). However, if these two move in opposite directions
with the same magnitude, the effect is netted out and the ADR price remains the
same.

We find
that, the way changes in ADR returns relate to changes in the S&P 500
Index, Nifty index and exchange rate differs from how ADR prices change
subsequent to changes in underlying stock prices. The contemporaneous changes
in Nifty index positively influence ADR returns, followed by a significant
(mostly negative) price response on the following days. The exchange rate emerges
as significant for some stocks at different lags. Thus, while ADRs seemingly
under react to information on underlying securities and overreact to
information on their own lagged values in gradual diminishing magnitude, this
is not the case with market indices.

This
indicates that information transmission to and from the domestic and U.S.
markets is not completely efficient. It is reasonable to conjecture that
besides market frictions, such as conversion fees and capital control
restrictions (e.g. the famous headroom issue), the mis-pricing is due to
varying expectations of investors in these two markets.

Thursday, July 4, 2013

Vishal was waiting for me at the
cafeteria when I went to get my usual cup of the morning coffee. He has been
investing small amounts of money in the stock market with reasonable success.
He would usually stop by to tell me about the performance of the stocks in
which he has invested. Today he looked troubled.

Nicky: What is it Vishal?

Vishal: Professor Nicky, you must
help me. My dad will beat me.

Nicky: Why? What happened?

Vishal: Last few weeks have been
pretty bad. The SENSEX has been shedding points and the prices of the stocks I
hold have also been going down. My dad has threatened to stop my pocket money
and force me to withdraw all my investments from the stock market if there are
any further losses.

A lot of the newspapers are
talking about the withdrawal of Quantitative Easing by the US. They say that it
will result in foreign institutional investors withdrawing money from the stock
markets in India.

I don't understand any of it.
Firstly, what is Quantitative Easing (QE)? Secondly, why should Indian markets
go down if US withdraws QE?

Nicky: I am glad that you are
reading the papers.

Quantitative Easing is a means to
increase money supply or liquidity in the economy to stimulate growth.
Countries like the US, Japan, UK and the Euro Zone, decided to infuse capital
into their economy by buying corporate bonds, equities or mortgage backed
securities.

Vishal: From what I know, these
countries have huge debt and high fiscal deficit. Where do they get the money
to infuse it into the system?

Nicky: Simple. They print it.
Printing money does have the danger of making the domestic currency weaker. But
the idea is to promote growth by increasing consumption, development and
expansion. That is demand.

When the government supplies
capital, some of the money finds its way to emerging countries like India, as
the interest rates in emerging countries are much higher than in US, Japan, UK
or the European Union. Some of this money also goes into the stock markets in
the hope of better returns than the investors would find in their own
countries.

When the Chairman of the Federal
Reserve of US, Ben Bernake, announced plans to taper down the QE last month, it
resulted in foreign institutional investors withdrawing money from emerging
nations, including India. This resulted in the markets going downhill.

Vishal: You said that printing
money has the danger of making the domestic currency weaker. But dollar is
becoming stronger.

Nicky: Dollar is getting stronger
as it is still seen as a safe haven. Also, the rate of dollar appreciation
increased after the announcement of tapering the QE came.

Vishal: We are truly living in an
integrated world. I must not just look at the Indian economy when taking
decisions, but also the global economy.

For six years starting in 1999,
Dr. Ishrat Husain was governor of the Central Bank of Pakistan. He was
responsible for a significant restructuring of the central bank and
implementation of banking sector reforms. During his tenure, a court decision
mandated that the nation's banking system conform to Islamic law. Husain's
skillful oversight helped to maintain banking sector stability during a period
of economic growth.

"Islamic banks did not
suffer as much during the financial crisis as conventional banks because they
did not deal in exotic derivatives or artificial money creation instruments
such as collateralized debt obligations," Husain observes.

"There
should not be a division between
the central bank and supervisory
authorities," says former Central Bank of
Pakistan governor Ishrat Husain.

As central bank governor, he was
a member of the government's economic management team. Later, from 2006 to
2008, he was chairman of the National Commission for Government Reforms,
reporting to the president and prime minister. In March 2008 he took charge of
the office of the dean and director of the Institute of Business
Administration, Karachi, the oldest graduate business school in Asia. He was
also a member of the Mahathir Commission 2020 and advised the Islamic
Development Bank on the creation of its poverty reduction fund.

With degrees from Williams
College (master's in development economics) and Boston University (doctorate in
economics), Husain also graduated from the joint executive development program
of Harvard University, Stanford University and INSEAD. He spent much of his
earlier career with the World Bank, including as head of the Debt and
International Finance Division and chief economist of the East Asia and Pacific
region.

Author of numerous books and
monographs including "Pakistan: The Economy of the Elitist State"
(Oxford University Press, 1999), Husain is currently a member of the
International Monetary Fund's Middle East Advisory Group and the United Nations
Development Program's Regional Advisory Group; chairman of the World Economic
Forum Global Advisory Council on Pakistan; and board member of the Benazir
Income Support Program, the largest social safety net and conditional cash
transfer program serving the poor in Pakistan.

In this recent interview --
conducted by Dr. Nupur Pavan Bang (Nupur_Bang@isb.edu),
senior researcher, and Dr. Vikram Kuriyan, director of the Centre for
Investment, Indian School of Business,
Hyderabad -- Husain reflects on the introduction and development of Islamic
banking in Pakistan, as well as risks faced by the conventional banking system,
financial crises and the challenges faced by emerging economies.

Please give the historical
background on the origin and development of Islamic banking in Pakistan.The Supreme Court of Pakistan has
an appellate bench that deals with Islamic laws. Someone approached this bench
in 2000 and represented that the banking system in Pakistan was anti-Islamic,
as it is based on usury and exploitative interest rates and Islam is against
usury and exploitation. Thus, the banking system should be declared illegal.
The court decided that by June 30, 2001, all banks should conform to Islamic
banking, and the existing banking system should be abolished. I was astonished
because the repercussions on the economy of such a drastic measure were not
fully realized. The economy would have been completely dislocated if a change
of such a magnitude was implemented in a short period of time.As central bank governor, I
formed a commission for the transformation to Islamic banking. The commission
comprised academicians, practitioners, bankers and Islamic scholars. It
recommended that there should be a parallel banking system that allows Islamic
banking to coexist with conventional banking. The choice would be available to
consumers to shift from conventional banking to Islamic banking if they wished
to do so. If every consumer decides Islamic banking, it will emerge in the
country. I persuaded the cabinet and the president that we would implement the
Supreme Court decision in a practical way that did not adversely affect the
smooth functioning of the economy. The decision ought to be taken by 28 million
customers whether they wish to opt for Islamic banking, and not by the
government or the central bank. On this basis, we introduced Islamic banking in
2001 and provided the regulatory framework.

What options were available to
the public?

We decided that there could be
three forms of Islamic banking. First, full-fledged Islamic banks could be
established and licensed if they met the prescribed criteria. Second,
conventional banks could set up a subsidiary bank that would be totally
separate in terms of deposits, assets, balance sheets, etc. Third, the
conventional bank can have Islamic banking windows that operate independent of
the conventional bank without any commingling of deposits and assets. They
would offer only Islamic instruments and products to the public. Meezan Bank
was the first to apply to become a full-fledged Islamic bank, and it was
granted the first license. It has since done extremely well with innovative
products, services and staff. It is the market leader with a one-third market
share.

What is your view on Islamic
banking in the context of the recent crisis?

There are two characteristics of
Islamic banking which distinguish it from conventional banking. One is that
every transaction has to be backed by real assets. Every loan should be backed
by collateral such as real estate, business, etc. You cannot create wealth or
money without associating it with real wealth creation.

Second, the borrower is a partner
in the business in which the bank has invested as financier. There is no
guaranteed fixed rate of return. If the business is not doing well, the bank
will suffer along with the account holder. In contrast, conventional banks
offer a fixed return to depositors. The bank has to pay interest irrespective
of the performance of assets.

In Islamic banking there is no
predetermined interest rate. The rate is determined at the end of the year
based on the profits and losses. These distinguishing features of Islamic
banking, if applied to International banking, would have avoided the
possibilities of panic, failure and crisis. The fact is that Islamic banking is
too small and insignificant to contribute to the safety of the international
banking system, because 98% of the banking is done in the other way.

What major reforms are
necessary to prevent future crises?

First, there should be separation
between trading and retail banking, because banks have become trading platforms
putting the depositors' money at risk. Assets are piled up, and buying and
selling happens at prices which are not related to the intrinsic value of the
underlying assets. That is what the Dodd-Frank legislation and the Volcker Rule
in the U.S. are about -- that client-based trading should be separate from
proprietary trading. Proprietary trading should be carried out separate from
the main bank and limited in scope.

Second, the bank should have
adequate capital. In manufacturing and services sectors, 60% to 70% is
shareholders' money and 30% to 40% is borrowed. The financial services business
is quite different. Shareholders' equity is 7% to 8%, and 92% of the money
belongs to depositors. If shareholders take excessive risk with the depositors'
money, the upside gains are captured by the shareholders and managers, and the
depositors don't get anything extra. But, if they lose money, taxpayers have to
bail them out. This asymmetric relationship in incurring risk and appropriation
of reward makes the financial sector more vulnerable to exogenous shocks.
Indian and Pakistani central banks had tough regulations, and thus their
banking systems survived during crises. This was not the same in the U.S. and
Europe.

What are your views on Basel
III?

I believe the capital and
liquidity buffers are appropriate, but the risk-weighting schema needs to be
carefully reviewed. Internal models do not always adequately capture the risks
assigned to different loans, and the supervisors have to develop the capacity
to test the veracity and accuracy of these internal models by rigorous stress
testing. Risk management systems and internal controls within the banks,
particularly the systemically important institutions, have to be strengthened
and examined from time to time.

What can the emerging markets
learn from the crisis? Can it happen in India and Pakistan?

The crisis can happen there if
financial institutions are not continuously monitored and supervised. It is
asymmetric risk taking in the sense that all positive gains are preempted by
shareholders and managers and losses are borne by someone else. Therefore,
government regulation becomes important. This was not done in the U.S. and
Europe. In India and Pakistan, shadow banking was not allowed to emerge, exotic
products were discouraged, and cautious liberalization was pursued in respect
to capital account opening. These are the safeguards that need to be observed.

A lot of countries are facing
very high debt-to-GDP ratios and fiscal deficits. Are populist politics and
subsidies to blame?

The starting point and initial
conditions of a country determine what policies need to be pursued. The current
debate between fiscal and monetary stimulus versus fiscal austerity cannot be
taken as an abstract proposition, but rather in the context of prevailing
circumstances. If Spain has half of its youth unemployed, fiscal austerity
measures over an extended period of time will become politically and socially
unacceptable. Japan, despite having a very high debt-to-GDP ratio, has recently
decided to embark on monetary easing because for the last 15 years the economy
was trapped in low-level equilibrium and was not able to come out of it.

Is austerity the answer?

No. Lending standards by the
banks should not be compromised, and credit should flow to the private sector
to stimulate the economy if public sector imbalances do not permit this. We
should not overextend and must learn from the subprime mortgage crisis. Why
should we give a loan to a person who does not have income to qualify for a
loan? The lenders were assuming that the price of housing will keep on going up
and the owner's equity in the house will be built up, enabling him to repay the
loan. That was a wrong premise -- it was unrealistic to expect a unidirectional
movement of housing prices.

What about regulatory and
political challenges in emerging markets, particularly South Asian countries?

South Asian countries must
strengthen their supervisory and regulatory bodies. There should not be a
division between the central bank and supervisory authorities. The Financial
Services Authority model in England that everyone cheered did not work out, and
supervision has gone back to the Bank of England. This is because the central
bank has information both at the macro and micro level, but the FSA had
information only at the micro level. They could not use macro-prudential
regulation to supplement the micro-prudential measures. Furthermore, they did
not have bank resolution authority that the Bank of England had as the lender
of last resort. Likewise, South Asia should strengthen its central banks and
not have separate regulatory bodies.

Is Africa the next BRICS?
Which countries might investors look at favorably?

Africa has done remarkably well
in the last decade. It has grown at 5% a year on average. And this pattern was
not limited to the commodity- and oil-producing countries, but also encompassed
Ghana, Kenya, Tanzania, Rwanda, Mozambique and others. Investment opportunities
in Africa are enormous, and the first-mover advantage will certainly help.

What challenges does Africa
face as the next investment destination?

Political instability and
fragility of institutions of governance continue to pose serious risks,
although this varies from country to country. Investors have become more
discerning; they do not treat Africa as a monolithic, homogeneous territory and
are selective in their choices. The effect of these choices on the countries
that are left out is positive, as they also take measures to improve their
policies and business environment.

Financial inclusion and
financial literacy are challenges for many emerging nations. What is the way
out? Do multilateral organizations like the World Bank and IMF have a role to
play?

I think the multilateral
institutions can only provide the lessons of experience and exchange
information as to what has worked and what has not in some countries. The
primary responsibility for raising awareness and financial literacy remains
with the central banks and governments. The conditions of each country differ,
and therefore the solutions have to be tailor-made and specific.